It’s widely and commonly believed good stock returns require strong GDP. And that’s true! Sort of. (And not in the long term—see Bunk 10 for why supply sets price in the long term, making all correctly calculated categories’ returns almost equal with widely varying paths en route.) But different types of stocks shine in weaker versus stronger economies.
Some stocks are defensive in nature and tend to do better relatively when GDP is weaker—sectors like Consumer Staples, Health Care, and Utilities—though not always and everywhere. When times are tough, folks don’t upgrade their TVs and go on cruises so much (or somewhat more prosperous folks who are struggling nonetheless might buy a new TV instead of going on a cruise), but they typically do keep buying toothpaste and electricity and aspirin. (If times are really tough, maybe they need more aspirin! See Bunk 39.) So those kinds of stocks typically do better than the market overall in downturns—though you can certainly find periods historically in a strong economy when they do fine too.

Stocks Move First—Up or Down

But there are two problems with this thinking: First, stocks lead the economy, not the other way around. If you wait for confirmation from the economy before making a move—you can pay big. (See Bunk 9.) For example, the US economy did fine overall in 1981, growing 2.54 percent1—though a recession started midyear. 2 Stocks knew it was coming—falling 4.9 percent for the year.3 GDP was positive, yet stocks fell!
That recession lasted until November 1982, and GDP shrank 1.94 percent that year.4 But stocks started pricing in the coming recovery, moving higher before the economy—up 21.6 percent in 1982.5 Negative GDP—yet hugely positive stocks! If you looked just at GDP—expecting it to tell you which way the market was going, you would have missed that.
The same thing happened in 2000 when real US GDP grew 4.14 percent.6 Way above average! But US stocks peaked and started their first down-leg of a major bear market in March, falling -9.1 percent in 2000—signaling the 2001 recession.7 Stocks peaked in 2007 and started falling before the 2007-2009 recession began. GDP was actually positive in 2008, though flattish—growing 0.44 percent for the year.8 Not much, but stocks fell a big 37.0 percent.9 In 2009, stocks turned up in March, but the economy didn’t turn positive until Q3. Though growing by year end, US GDP shrank 2.44 percent in 2009, while US stocks boomed 26.5 percent.10 The positive Q3 GDP reading was first released at the end of October. If you waited for that, you missed a 31.5 percent move in US stocks from the March low.11 Stocks move first—up or down.
Second problem: Even during a growth cycle, stocks can be below average when growth is above average, and vice versa. In 1992, real GDP growth was nicely above average—3.4 percent—but stocks returned a fairly lackluster 7.6 percent.12 In 1995, GDP grew 2.5 percent.13 That is below the average since 1980 and a laggard in the overall booming 1990s. Meanwhile, stocks soared 37.6 percent—way above average.14
What gives? Even during periods of strong growth, expectations can get out of whack. Maybe the consensus is for very strong growth—way above average. If growth is above average but below prior expectations, that can disappoint—usually not enough for a bear market, but enough for returns to be muted. Same thing in reverse. Maybe folks are expecting much weaker growth, and if growth is better than expected while still below average, that can boost returns.15 Ultimately, surprise moves the market in the intermediate term, for good or for bad.
And never forget! Stocks look forward, while GDP measures what just happened and is released at a lag. So while economic growth is an overall market driver, don’t expect it to be a perfect market indicator or any form of leading indicator. It isn’t.

Huge Growth—Wildly Variable Returns

The US is a huge developed nation—the largest economically by a long shot. In smaller developed nations, you can get even more disconnect. And GDP can make folks’ brains go even more haywire in emerging markets.
China has had huge growth in recent years—topping 13.3 percent in 2007!16 (See Table 49.1.) And China has had some huge market years—up 87.6 percent in 2003, up 82.9 percent in 2006, and up 66.2 percent in 2007.17 Except Chinese GDP grew 9.3 percent in 2008 when stocks plummeted 50.8 percent.18 And Chinese stocks fell huge in 2000, 2001, and 2002—when its economy boomed.
It’s normal to see emerging nations (those that are emerging successfully—some emerge, others submerge) have huge GDP growth—even for years in a row. As the nation grows, it has huge per capita GDP gains. As more of its citizenry moves up into an emerging middle class, they start purchasing cars, appliances, electronics, etc., which also fuels growth. It can feed on itself for a while since growth requires more infrastructure build-outs that result in greater wealth and more growth—and the need for more infrastructure, etc. etc.
Plus, though China remains officially “communist,” it has loosened its economy tremendously (relatively). A lot of that growth is years of suppressed ingenuity and productivity hitting its economy all at once. Can it continue? Sure. But China could certainly mess it all up—fast. But there’s no inherent reason (other than government meddling) China has to slow down. It slowed somewhat in the global recession in 2008 and 2009—if you can call 8.5 percent slow. But nearly a billion Chinese remain at levels Americans would consider worse than poverty. The growth potential there, if the government allows it, could be huge for a long, long time.
Table 49.1 Chinese GDP and Stock Market Returns—Stocks Don’t Necessarily Reflect GDP
Source: International Monetary Fund, World Economic Outlook Database; Thomson Reuters, MSCI China Total Return in US dollars.
Year China Real Annual GDP MSCI China Returns
But none of that has much to do with the stock market. Thanks to its fast growth, China is now much bigger than even 10 years ago—now about 8.5 percent of global GDP and the third largest single economy (as of year-end 2009) behind the US and Japan.19 Huge! If it continues at its current growth pace, it will surpass the US before long. But its stock market is relatively tiny—just 2.26 percent of the world20—much smaller than you’d think an economy that size should be. (I’m only counting those stocks that non-Chinese can purchase. There are stocks the Chinese government limits to Chinese nationals, but since we’re thinking globally, we want to focus on stocks the globe can buy.) Its capital markets are tiny and lack depth and diversity—very common for emerging markets—adding to volatility. Another big key to demand for Chinese stocks moving forward is the unpredictable flow of new supply of Chinese shares (again, see Bunk 10). In the long term, supply flows control pricing. In the short term, demand shifts do.
Emerging markets typically are also less stable politically, which impacts both supply and demand. This isn’t the case with South Korea or even Brazil so much anymore, but many emerging markets (even China, though China is no Venezuela—eek) have miserable private property protections. That adds still more variability you don’t get in developed nations, which is why emerging nations can have market returns hugely detached from their economies, with huge shifts in both demand and supply for stocks.
The truth is—emerging or developed—GDP is a great read of where the economy was. But if you expect GDP to be predictive of market direction, you can get whipsawed big time.
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